Nkoso Ltd (Nkoso) is an agro-processing company which reports under International Financial Reporting Standards up to 31 December each year.
On 10 October 2019, Nkoso organised a Christmas party at the company’s head office in Accra. Unfortunately, there was an incident of food poisoning and the company has received 500 legal claims from victims of the food poisoning, seeking compensation of an average of GH¢5,000 each. A letter from Nkoso’s legal advisors, dated 10 December 2019, suggests 40% of these claims are likely to be successful.
The Accountant of Nkoso does not want to make any provision for these claims on the grounds that less than 50% of the cl aims are likely to be successful. The legal advisors have suggested that an average of two years from the end of the current reporting period will elapse before the claims are settled. The risk related discount rate is estimated to be 10%.
Required:
In accordance with IAS 37: Provisions, Contingent Liabilities and Contingent Assets, advise the directors of Nkoso on the appropriate accounting treatment of the above in the financial statements for the year ended 31 December 2019. (6 marks)
View Solution
The food poisoning claims are covered by IAS 37 Provisions, Contingent Liabilities and Contingent Assets. If there was a single claim, then it would be classified as a contingent liability, and no provision should be recognised in the SFP. This is because the outcome is possible not probable.
However, because there are 500 claims and each one has a 40% chance of succeeding, then overall Nkoso would expect to lose 200 claims. Therefore, a provision should be recognised in the SFP because:
- There is an obligation at the end of the reporting period due to a past event
- There is a probable outflow of economic resources
- A reliable estimate can be made (200 claims at GH¢5,000 each)
Because the claims are not expected to be settled for another two years, the provision should be discounted using the risk related time value of money. The provision should therefore be carried in the SFP at 31 December at:
500 X 5,000 X 0.40 X 1/(1.10)2 = GH¢826,446
. GH¢m GH¢m
Dr SPLOCI (retained earnings) 0.8
Cr Provisions (NCL) 0.8
Explanation of the treatment in IAS 37 or provisions and contingent liabilities, stating the conditions: 2 marks
Amount of provision to be recognized taking into consideration the discount rate 2 marks
Journal entries for the provision 2 marks